The great contribution of Prospect Theory to expected utility theory and economic theory in general, was consideration of the reference point and the finding that “losses loom larger than gains”. It was found that humans weighed loses approximately twice as much as they did gains. A new psychological perspective considered the impact that emotions have on the (not always rational) human decision-maker. Prospect Theory documented “losses looming larger than gains” through various examples of loss aversion when people made irrational decisions based on a fear of losing what they already had in hand. Regret, fear of regretting one’s actions later, disappointment, sadness, and the impact such emotions may have on one’s own self-worth and confidence is something that psychologists found that effect decision-making and behavior in the future. Predicting rational logical decision-makers, morphed into understanding the decision-makers’ perspective, their reference point, where they came from, and where they had arrived at the time of the decision – that is, the emotional human.

It is believed, due to the effect of loss aversion, humans have a preference for the status quo. Opting for the status quo, even if it lacks desirability, seems to be preferred over the risk of loss. Even if the new option may appear to have many preferable qualities. The fear of the unknown, which may be worse, results in an irrational preference for not changing from the status quo. That is the disadvantages of change looming larger than the advantages of change (Kahneman, 2011, p. 292).

As humans, we are readily adaptable to any new situation but subsequently, we adapt to our current situation and use it as a reference point for favoring small changes over large changes. Nevertheless, the assumption that one’s current state is all that matters is inaccurate, as well. “Remember where you came from” is a common phrase that also plays a role in the decision-makers’ perspective. Maybe that is why we somehow trust a person who came up from meager means over a person who came from privilege. Maybe we subconsciously know that the person who came from meager means may have more perspective, resulting in an ability to consider not only people’s perspective who share their current status but also is influenced by how important certain things were to them when they were seeing things from a different perspective. Understanding all this is how the field of behavioral economics developed.

In the 1970’s, Richard Thaler was questioning the questions that couldn’t be answered by traditional economic theory and finding answers in the newly adopted Prospect Theory. He went on to collaborate with Daniel Kahneman and Jack Knetsch in Canada. Thaler referred to the notion of irrationally not wanting to give up or sell a belonging or investment for anything under an extreme profit, as the endowment effect. This emotional reaction to trading something someone had in hand for something far above what they would be willing to buy it for was documented by him repeatedly and could not be explained by traditional economic theory which said people would be willing to sell something for a cost that they would be willing to buy it.

Very interesting to me, was that they found differences in this behavior between cultures/countries. For example, American sellers wanted more than double the money than they would be willing to buy the same object. People who could just trade an object for another object, also valued the object they had as slightly more than the object they were willing to take. The mere fact that they had one of the objects in their possession, raised the value of that object in their eyes. Whereas, in the United Kingdom this trend was not found and sellers kept their selling price much closer to what they would be willing to buy it. That made me wonder how the study would play out in Denmark, a country with a strict sense of equality between people and rated as one of the most happy countries in the world.

Why do Americans, as an individualistic people, tend to over value the things we have when considering selling the item? It sounds a bit insecure. It sounds like we are fearful of letting go of something we have if it might have any monetary or emotional value to ourselves or others, now or in the future. Why do we place a value on something as twice as much as we would be willing to pay for it? Is it that we are a greedy people who are always trying to have or acquire more than the next person so we want to get the absolute most we can for anything and everything? Are we so insecure in our financial worth, that we are in need to raise it with every opportunity out of fear for our future stability? Are we insecure in our social status, that if we have something someone else wants than that makes it worth more to us emotionally? Is it just neurochemical and ingrained in our competitive culture, that we have more dopamine release when we know we have something that someone else wants and therefore we value it more and must keep it as it is the source of dopamine release? Why do people in the UK not have the same reaction? Are they happier than Americans? Are they more secure in their own financial or social status?

Reference

Kahneman, D. (2011). Thinking Fast and Slow  . New York, NY: Farrar, Straus, and Giroux.  Part 4  – “Choices”: Chapter 26: Prospect Theory (pp. 269 – 288) & Chapter 27: The Endowment Effect.